The Anatomy of a Capital Destruction

Austrian School economists have a favourite term: mal-investments.  It refers to the misallocation of capital bought about by artificially low interest rates induced by money pumped into the commercial banking system by the central bank.

Investment decisions in the here and now are based on discounted expected returns over the life of the venture.  If an entrepreneur can borrow 10-year funds at an artificially set 3%, he will calculate a given level of capital investment far more profitable over the coming decade than if he had to borrow money at the market determined interest rate of say 6%. 

Due to the nature of compounding and discounting, longer term investments become especially more attractive relative to short term ones for a given fall in the rate of interest.  For example, the difference between funding R1 million at 3% vs 4% over 1 year is far smaller than funding R1 million at 3% vs 4% over 10 years.   This makes long term investment decisions far more sensitive or elastic to changes in interest rates than short term ones.  This is a key component of Austrian Business Cycle Theory and a major reason for capital destruction under artificially loose monetary policy.

When the Fed or the SARB pushes interest rates below where the market would determine, and/or engages in quantitative easing, investors are drawn to the exaggerated profitability of long term projects.  The rate of interest is supposed to convey time preference of people in the economy.  A low rate of interest shows that people place less of a premium on current consumption vs future consumption and are therefore willing to defer consumption into the future.  This message is conveyed to entrepreneurs who then invest in long term capital projects that will meet consumption demand in the future.

When the state and its central bank artificially lowers the rate of interest it obscures completely the real time preference message that society is usually able to convey to entrepreneurs.  Investors are led to believe that demand for products in the future will be stronger and that projects will be more profitable than is actually the case.

Reality bites

Initially the inflation in the money supply that facilitated artificially cheap credit leads to general price increases across the economy.  Wages and raw material costs are bid up, and the market starts to demand higher interest rates.

As capital market rates rise investors quickly see that the real time preference of society favours consumption now relative to the future to a far greater degree than the artificially low interest rate had signalled.  Because entrepreneurs were borrowing credit that was created out of thin air from new central bank created money and not from the savings of households, it meant households were not forgoing immediate consumption and credit demand to fund the longer term investments.

Bottom line: while households spent it up and got into more debt (necessarily meaning deferred consumption in the future), entrepreneurs were creating capacity to service future demand that would not materialise.

The over-investment or mal-investment in these longer term capital projects is a waste and the economy soon realises it has allocated capital incorrectly.  Business owners now need to rapidly liquidate these poor investments.

For those economists still in agreement with the Austrian School up to this point the next step is often their departure. For somehow in most modern economic theory capital is treated as some abstract amorphous mass that is slotted into the right hand side of a growth equation.  It doesn’t really matter what capital you have or where it is, as long as it’s there doing its job in augmenting productivity and output.  As long as the ‘capital stock’ is growing, it’s happy days for these folk.

Real life is not so grand.  Capital is not a lump of happiness to be dumped at will wherever we poor souls need it to lift our economic spirits.  Capital is real, complex, and immovable.  It is technical, mechanical, and specific.  It is perishable, imperfect, and prone to technological redundancy.

Once built, plant and machinery for a particular industry cannot simply be morphed into ‘capital’ used in another sector.  A machine used for making cars can’t make chocolates.

And so, as the mal-investments are exposed, some, such as warehousing space or vehicles, can be liquidated and used in other industries, but others, like specialised machines and factories, lie dormant, and eventually decay and die.  If you’ve ever seen a factory with broken windows and weeds growing around it, you’ve seen the ugly result of the phenomenon just described.

Wealth is permanently destroyed by the inflationary policies of the government and its central bank – never to be reclaimed.  Society is poorer.  Artificially low interest rates is one big con-job, and hard working people are hurt the most.

That is the anatomy of capital destruction.